Endangered estate planning tools? At least we still have life insurance

With all of the speculation, legislation and uncertainty related to transfer tax laws, have you ever felt like Hansel and Gretel after they could not find the bread crumbs? If so, you might wonder where tax-oriented estate planning is these days.

For most people, tax-wise estate planning today typically still begins with use of the estate tax marital deduction. This is because the deduction provides that all the property you leave to your spouse at your death passes free of federal estate tax.

Free, that is, until the surviving spouse dies. Then it is exposed to estate tax as a part of the surviving spouse’s estate. This means the use of the marital deduction does not eliminate the tax exposure. Rather, it just postpones it until the second death.

Any attempts to actually avoid the estate tax involve giving property away. Because if you own something when you die, it is a part of your gross estate and exposed to the tax. The problem with giving away property is that if you give away more than a certain amount, you have to pay a gift tax.

To lessen the impact of the gift tax, there are estate planning techniques designed to reduce or discount the value of the property that is given away and, thereby, reduce exposure to the gift tax. These techniques work because the gift tax applies to the value of what you give away. If you can reduce that value, you reduce the amount of gift tax you have to pay.

Use them or (maybe) lose them

It is the effectiveness of certain popular techniques in legitimately reducing gift tax exposure that has caused various members of Congress and the Obama administration to seek to eliminate or restrict them. Specifically, I am referring to the use of family limited partnerships, grantor retained annuity trusts (GRATs) and installment sales to a grantor trust. In any case, what follows is a brief summary of the salient points of each concept.

Family limited partnerships: Clients with a business they want to transfer to family members may consider moving their business into a FLP. The owner can then transfer some of his or her FLP interests to family members using the annual gift tax exclusion and $5.25 million gift tax applicable exclusion. In doing this, the client will be entitled to valuation discounts on the gifts for lack of marketability and lack of control. That permits leveraging of the annual exclusion and $5.25 million applicable exclusion.

For example, assume parents with three children and a business worth $20 million want to transfer the business to their children. If the parents place the business into a FLP, they can give the children $16,283,076 worth of limited partnership interests, gift tax free, in the first year, assuming a 35 percent discount ($10.5 million gift tax applicable exclusions plus $84,000 of annual exclusions). This means that by using the FLP, the parents are able to give the children an additional $5,699,076 gift tax free because of the 35 percent discount ($16,283,076 minus $10,584,000).

Grantor retained annuity trusts: A GRAT is a type of irrevocable trust that allows a parent to transfer income-producing assets to the trust in exchange for an income interest for a term of years. At the end of the income period, the trust remainder passes to the children as a gift. The value of that gift is determined using certain government interest rates. If the property in the trust grows faster than the government interest rates, the gift is undervalued for gift tax purposes.

For example, if a 65-year-old business owner had transferred $1 million of his company stock to a GRAT in March 2009 and retained the right to receive 4 percent, or $40,000, per year for 10 years, that retained right to income would have been worth $351,900. That would mean the gift of the remainder to family members was worth $648,100 and could have been offset against the owner’s gift tax applicable exclusion. Further, if the stock in the trust earned 7 percent per year, the family would receive $1,423,983 at the end of 10 years. That is twice the value of the gift as determined for federal gift tax purposes.

Sale to an intentionally defective grantor trust: With this concept, a parent owning a business sets up a grantor trust for the benefit of the family members whom the parent wants to receive the business. Subsequently, the trust buys the business from the parent for an interest-bearing installment note. Our historically low interest rates make it easier for the trust to have enough income from the business to pay the notes.

For example, assume a parent sold a factory building with a tax basis of $500,000 to a grantor trust for a $1 million 9-year note on Jan. 15, 2011. The applicable Federal mid-term rate was only 1.95 percent, which would make it easier for the trust to pay off the notes using the trust’s income from the building. Another advantage is that if the building appreciated to $2 million by the owner’s death, the additional $1 million of appreciation would be excluded from the parent’s estate. Finally, since the sale is to a grantor trust, the parent may be able to avoid taxes on the $500,000 of capital gains from the sale.

The aversion to change

The problem with these three techniques from the taxpayer’s perspective is that, while they are legitimate tax avoidance concepts, they all have two features in common. First, they require the taxpayer to change how he or she owns or manages property, and secondly, they require the taxpayer to make large estate-reducing gifts.

These two steps present problems for many taxpayers because, as people get older, they don’t like change. Consequently, many feel like they are caught between the proverbial rock and a hard place. This is because if they give the property away, they are making a change, but if they don’t, their estate is going to pay an estate tax.

A palatable alternative

This is where life insurance comes in as a palatable alternative to change. That is because rather than giving property away, clients can just purchase life insurance to cover the tax.

They must be careful, however, about how they arrange for the purchase and ownership of the insurance. If they own it when they die, it will be included in their gross estate and exposed to estate tax.

To avoid this problem, most who take this route establish an irrevocable trust and make relatively small gifts to the trust with which the trustee can purchase the life insurance. Then, upon the insured’s death, the trustee makes the death proceeds available to the decedent’s executor to pay any estate tax through purchases of assets form the estate or loans to the estate.

A balanced result

From the government’s perspective, as long as the insurance is purchased by the trust and the insured never has any ownership interest in the policy, the death proceeds will not be included in the insured’s gross estate. Moreover, the government is placed in a better position because cash is immediately available from the estate to pay any estate tax liability.

In that regard, you should understand that the estate tax is generally due within nine months of the decedent’s death. That being the case, imagine how many estates are too illiquid to be able to come up with the cash in just nine months. For example, think of those owning real estate or closely held family businesses that are not easily disposed of and might require a fire sale to generate cash to pay the tax.

Hence, life insurance becomes the palatable alternative that prefunds the tax liability for the decedent’s estate and assures the government that it will receive its revenue in the allotted time.